test bank of corporate finance 11th jaffe jordan chapter 31

The dollar is selling at a premium because it is more expensive in the forward market than in the spot market SF 1.11 versus SF 1.09.. The franc is expected to depreciate relative to th

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CHAPTER 31

INTERNATIONAL CORPORATE

FINANCE

Answers to Concepts Review and Critical Thinking Questions

1 a The dollar is selling at a premium because it is more expensive in the forward market than in the

spot market (SF 1.11 versus SF 1.09)

b The franc is expected to depreciate relative to the dollar because it will take more francs to buy one dollar in the future than it does today

c Inflation in Switzerland is higher than in the United States, as are nominal interest rates

2 The exchange rate will increase, as it will take progressively more pesos to purchase a dollar This is the relative PPP relationship

3 a The Australian dollar is expected to weaken relative to the dollar, because it will take more A$

in the future to buy one dollar than it does today

b The inflation rate in Australia is higher

c Nominal interest rates in Australia are higher; relative real rates in the two countries are the same

4 No For example, if a country’s currency strengthens, imports become cheaper (good), but its exports become more expensive for others to buy (bad) The reverse is true for currency depreciation

Westerfield, Jaffe, and Jordan

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5 Additional advantages include being closer to the final consumer and, thereby, saving on transportation, significantly lower wages, and less exposure to exchange rate risk Disadvantages include political risk and costs of supervising distant operations

6 One key thing to remember is that dividend payments are made in the home currency More generally,

it may be that the owners of the multinational are primarily domestic and are ultimately concerned about their wealth denominated in their home currency because, unlike a multinational, they are not internationally diversified

7 a False If prices are rising faster in Great Britain, it will take more pounds to buy the same amount

of goods that one dollar can buy; the pound will depreciate relative to the dollar

b False The forward market would already reflect the projected deterioration of the euro relative

to the dollar Only if you feel that there might be additional, unanticipated weakening of the euro that isn’t reflected in forward rates today, will the forward hedge protect you against additional declines

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c True The market would only be correct on average, while you would be correct all the time

8 a American exporters: Their situation in general improves because a sale of the exported goods for

a fixed number of euros will be worth more dollars

American importers: Their situation in general worsens because the purchase of the imported goods for a fixed number of euros will cost more in dollars

b American exporters: They would generally be better off if the British government’s intentions result in a strengthened pound

American importers: They would generally be worse off if the pound strengthens

c American exporters: They would generally be much worse off, because an extreme case of fiscal expansion like this one will make American goods prohibitively expensive to buy, or else Brazilian sales, if fixed in reais, would become worth an unacceptably low number of dollars American importers: They would generally be much better off, because Brazilian goods will become much cheaper to purchase in dollars

9 IRP is the most likely to hold because it presents the easiest and least costly means to exploit any arbitrage opportunities Relative PPP is least likely to hold since it depends on the absence of market imperfections and frictions in order to hold strictly

10 It all depends on whether the forward market expects the same appreciation over the period and

whether the expectation is accurate Assuming that the expectation is correct and that other traders do not have the same information, there will be value to hedging the currency exposure

11 One possible reason investment in the foreign subsidiary might be preferred is if this investment

provides direct diversification that shareholders could not attain by investing on their own Another reason could be if the political climate in the foreign country was more stable than in the home country Increased political risk can also be a reason you might prefer the home subsidiary investment Indonesia can serve as a great example of political risk If it cannot be diversified away, investing in this type of foreign country will increase the systematic risk As a result, it will raise the cost of the capital, and could actually decrease the NPV of the investment

12 Yes, the firm should undertake the foreign investment If, after taking into consideration all risks, a

project in a foreign country has a positive NPV, the firm should undertake it Note that in practice, the stated assumption (that the adjustment to the discount rate has taken into consideration all political and diversification issues) is a huge task But once that has been addressed, the net present value principle holds for foreign operations, just as for domestic

13 If the foreign currency depreciates, the U.S parent will experience an exchange rate loss when the

foreign cash flow is remitted to the U.S This problem could be overcome by selling forward contracts Another way of overcoming this problem would be to borrow in the country where the project is located

14 False If the financial markets are perfectly competitive, the difference between the Eurodollar rate

and the U.S rate will be due to differences in risk and government regulation Therefore, speculating

in those markets will not be beneficial

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Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet Many problems require multiple steps Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred However, the final answer for each problem is found without rounding during any step in the problem

Basic

1 Using the quotes from the table, we get:

a $100(€.8031/$1) = €80.31

b $1.2452

c €5M($1.2452/€) = $6,226,000

d New Zealand dollar

e Mexican peso

f (P13.9334/$1)($1.2452/€1) = P17.3499/€

This is a cross rate

g The most valuable is the Kuwait dinar The least valuable is the Vietnam dong

2 a You would prefer £100, since:

(£100)($1.5649/£1) = $156.49

b You would still prefer £100 Using the $/£ exchange rate and the SF/$ exchange rate to find the amount of Swiss francs £100 will buy, we get:

(£100)($1.5649/£1)(SF.9655) = SF 151.0911

c Using the quotes in the book to find the SF/£ cross rate, we find:

(SF/$.9655)($1.5649/£1) = SF 1.5109/£1

The £/SF exchange rate is the inverse of the SF/£ exchange rate, so:

£1/SF1.5109 = £.6619/SF1

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3 a F180 = ¥118.37(per $) The yen is selling at a premium because it is more expensive in the forward

market than in the spot market ($.0084303 versus $.0084481)

b F90 = $.6394/£ The pound is selling at a discount because it is less expensive in the forward market than in the spot market ($1.5649 versus $1.5640)

c The value of the dollar will fall relative to the yen, since it takes more dollars to buy one yen in the future than it does today The value of the dollar will rise relative to the pound, because it will take less dollars to buy one pound in the future than it does today

4 a The U.S dollar, since one Canadian dollar will buy:

(Can$1)/(Can$1.13/$1) = $.8850

b The cost in U.S dollars is:

(Can$2.50)/(Can$1.13/$1) = $2.21

Among the reasons that absolute PPP doesn’t hold are tariffs and other barriers to trade, transactions costs, taxes, and different tastes

c The U.S dollar is selling at a premium, because it is more expensive in the forward market than

in the spot market (Can$1.13 versus Can$1.16)

d The Canadian dollar is expected to depreciate in value relative to the dollar, because it takes more Canadian dollars to buy one U.S dollar in the future than it does today

e Interest rates in the United States are probably lower than they are in Canada

5 a The cross rate in ¥/£ terms is:

(¥126/$1)($1.53/£1) = ¥192.78/£1

b The yen is quoted high relative to the pound Take out a loan for $1 and buy £.6536 Use the

£.6536 to purchase yen at the cross-rate, which will give you:

¥195.8(£.6536) = ¥127.9739

Use the yen to buy back dollars and repay the loan The cost to repay the loan will be:

¥127.9739($1/¥126) = $1.0157

Your arbitrage profit is $.0157 per dollar used

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6 We can rearrange the interest rate parity condition to answer this question The equation we will use is:

RFC = (FT – S0) / S0 + RUS

Using this relationship, we find:

Great Britain: RFC = (£.6400 – £.6390) / £.6390 + 019 = 0206, or 2.06%

Japan: RFC = (¥118.37 – ¥118.62) / ¥118.62 + 019 = 0169, or 1.69%

Switzerland: RFC = (SF.9632 – SF.9655) / SF.9655 + 019 = 0166, or 1.66%

7 If we invest in the U.S for the next three months, we will have:

$30,000,000(1.0017)3 = $30,153,260.25

If we invest in Great Britain, we must exchange the dollars today for pounds, and exchange the pounds for dollars in three months After making these transactions, the dollar amount we would have in three months would be:

($30,000,000)(£.64/$1)(1.0061)3/(£.65/$1) = $30,082,319.47

The company should invest in the U.S

8 Using the relative purchasing power parity equation:

Ft = S0 × [1 + (hFC – hUS)]t

We find:

Z3.41 = Z3.29[1 + (hFC – hUS)]3

hFC – hUS = (Z3.41 / Z3.29)1/3 – 1

hFC – hUS = 0120, or 1.20%

Inflation in Poland is expected to exceed that in the U.S by 1.20% annually over this period

9 The profit will be the quantity sold, times the sales price minus the cost of production The production cost is in Singapore dollars, so we must convert this to U.S dollars Doing so, we find that if the exchange rates stay the same, the profit will be:

Profit = 30,000[$115 – {(S$141.30) / (S$1.3043/$1)}]

Profit = $199,980.83

If the exchange rate rises, we must adjust the cost by the increased exchange rate, so:

Profit = 30,000[$115 – {(S$141.30) / 1.1(S$1.3043/$1)}]

Profit = $495,437.12

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If the exchange rate falls, we must adjust the cost by the decreased exchange rate, so:

Profit = 30,000[$115 – {(S$141.30) / 9(S$1.3043/$1)}]

Profit = –$161,132.41

To calculate the breakeven change in the exchange rate, we need to find the exchange rate that makes the cost in Singapore dollars equal to the selling price in U.S dollars, so:

$115 = S$141.30/ST

ST = S$1.2287/$1

ST = –.0580, or –5.80%

10 a If IRP holds, then:

F180 = (Kr 6.97)[1 + (.05 – 03)]1/2

F180 = Kr 7.0394

Since given F180 is Kr 7.06, an arbitrage opportunity exists; the forward premium is too high Borrow Kr 1 today at 5 percent interest Agree to a 180-day forward contract at Kr 7.06 Convert the loan proceeds into dollars:

Kr 1 ($1/Kr 6.97) = $.14347

Invest these dollars at 3 percent, ending up with $.14558 Convert the dollars back into krone as

$.14558(Kr 7.06/$1) = Kr 1.02779

Repay the Kr 1 loan, ending with a profit of:

Kr 1.02779 – Kr 1.02435 = Kr 00343

b To find the forward rate that eliminates arbitrage, we use the interest rate parity condition, so:

F180 = (Kr 6.97)[1 + (.05 – 03)]1/2

F180 = Kr 7.0394

11 The international Fisher effect states that the real interest rate across countries is equal We can

rearrange the international Fisher effect as follows to answer this question:

RUS – hUS = RFC – hFC

hFC = RFC + hUS – RUS

a hAUS = 04 + 0195 – 018

hAUS = 0415, or 4.15%

b hCAN = 06 + 0195 – 018

hCAN = 0615, or 6.15%

c hTAI = 09 + 0195 – 018

hTAI = 0915, or 9.15%

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12 a The yen is expected to get stronger, since it will take fewer yen to buy one dollar in the future

than it does today

b hUS – hJAP (¥114.35 – ¥115.13) / ¥115.13

hUS – hJAP = –.0068, or –.68%

(1 – 0068)4 – 1 = –.0268, or –2.68%

The approximate inflation differential between the U.S and Japan is –2.68 percent annually

13 We need to find the change in the exchange rate over time, so we need to use the relative purchasing

power parity relationship:

Ft = S0 × [1 + (hFC – hUS)]t

Using this relationship, we find the exchange rate in one year should be:

F1 = 251[1 + (.037 – 028)]1

F1 = HUF 253.26

The exchange rate in two years should be:

F2 = 251[1 + (.037 – 028)]2

F2 = HUF 255.54

And the exchange rate in five years should be:

F5 = 251[1 + (.037 – 028)]5

F5 = HUF 262.50

Intermediate

14 First, we need to forecast the future spot rate for each of the next three years From interest rate and

purchasing power parity, the expected exchange rate is:

E(ST) = [(1 + RUS) / (1 + RFC)]t S0

So:

E(S1) = (1.0310 / 1.0290)1 ($1.04/€) = $1.0420/€

E(S2) = (1.0310 / 1.0290)2 ($1.04/€) = $1.0440/€

E(S3) = (1.0310 / 1.0290)3 ($1.04/€) = $1.0461/€

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Now we can use these future spot rates to find the dollar cash flows The dollar cash flow each year will be:

Year 0 cash flow = –€$19,000,000($1.04/€) = –$19,760,000.00

Year 1 cash flow = €$3,600,000($1.0420/€) = $3,751,276.97

Year 2 cash flow = €$4,100,000($1.0440/€) = $4,280,591.42

Year 3 cash flow = (€5,100,000 + 12,700,000)($1.0461/€) = $18,620,151.63

And the NPV of the project will be:

NPV = –$19,760,000 + $3,751,276.97 / 1.105 + $4,280,591.42 / 1.1052 + $18,620,151.63 / 1.1053

NPV = $941,106.39

15 a Implicitly, it is assumed that interest rates won’t change over the life of the project, but the

exchange rate is projected to decline because the Euroswiss rate is lower than the Eurodollar rate

b We can use relative purchasing power parity to calculate the dollar cash flows at each time The equation is:

E[ST] = (SF 1.17)[1 + (.05 – 06)]t

E[ST] = 1.17(.99)t

So, the cash flows each year in U.S dollar terms will be:

And the NPV is:

NPV = –$21,367,521.37 + $5,957,005.96/1.12 + $6,017,177.73/1.122 + $6,077,957.31/1.123

+ $6,139,350.82/1.124 + $6,201,364.46/1.125

NPV = $494,750.33

c Rearranging the relative purchasing power parity equation to find the required return in Swiss francs, we get:

RSF = 1.12[1 + (.05 – 06)] – 1

RSF = 10.88%

So, the NPV in Swiss francs is:

NPV = –SF 25,000,000 + SF 6,900,000(PVIFA10.88%,5)

NPV = SF 578,857.89

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Converting the NPV to dollars at the spot rate, we get the NPV in U.S dollars as:

NPV = (SF 578,857.89)($1/SF 1.17)

NPV = $494,750.33

16 a To construct the balance sheet in dollars, we need to convert the account balances to dollars At

the current exchange rate, we get:

Assets = solaris 43,000 × ($ / solaris 1.20) = $35,833.33

Debt = solaris 14,000 × ($ / solaris 1.20) = $11,666.67

Equity = solaris 29,000 × ($ / solaris 1.20) = $24,166.67

b In one year, if the exchange rate is solaris 1.40/$, the accounts will be:

c If the exchange rate is solaris 1.12/$, the accounts will be:

Challenge

17 First, we need to construct the end of year balance sheet in solaris Since the company has retained

earnings, the equity account will increase, which necessarily implies the assets will also increase by the same amount So, the balance sheet at the end of the year in solaris will be:

Now we need to convert the balance sheet accounts to dollars, which gives us:

18 a The domestic Fisher effect is:

1 + R US = (1 + r US )(1 + h US)

1 + r US = (1 + R US )/(1 + h US)

This relationship must hold for any country, that is:

1 + r FC = (1 + R FC )/(1 + h FC)

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